Description

REFAC is a special situation investment opportunity that provides minimal risk, a significant expected return in a base-case scenario and the potential of outsized returns via a lottery ticket scenario.

REFAC originally planned to liquidate when a shareholder, Palisade Capital, approached management with a merger proposal that offered shareholders the option to either: 1) receive the proceeds they would have received through the liquidation – the “Base-Case” scenario; or 2) receive a major portion of the money that would have been available through the liquidation ($3.60 per share) and retain a continued interest in the surviving company – the “Lottery Ticket” scenario.

THE BASE CASE:

Subject to shareholder approval, REFAC has entered into a merger agreement that provides shareholders merger consideration of:

1) An amount equal to $3.60 in cash which I expect to be paid within three to four months; and

2) 0.2 shares of stock in a surviving corporation, and each such one whole share of the surviving corporation shall entitle the holder to a “Payment Right”. The Payment Right essentially has a value that is determined based on two formulas set forth in the merger agreement (to be discussed more below). The maximum value is set at $5.50 per share of the surviving corporation or $1.10 per current share (for simplicity I will refer to values based on current share prices and not the surviving corporation). The maximum value is obtainable, however, for my base-case scenario I assume the value of the Payment Right to be $0.80 per share and for my worst-case scenario I assume the value to be $0.52 per share. The Payment Right is only valid for a period of 19 days, by my guess in September 2005, and the shares need to be owned continuously from a date before the closing through the validation period.

Furthermore, the Payment Rights are secured by a contingency fund that adequately ensures that the surviving corporation is in a position to make good on all tendered Payment Rights.

Hence, purchasing the shares today at $3.83 I expect to receive $3.60 in three months and an additional $0.80 in 34 months. The IRR works out to be approximately 22 percent including transaction costs. My best-case and worst-case scenarios estimate an IRR of approximately 29 percent and 14 percent respectively.

THE LOTTERY TICKET:

Palisade Capital (www.palisadecapital.com) manages more than $2 billion worth of capital investing in small cap public equities, convertible securities and private equity funds. Via the merger they will control approximately 80 percent of the surviving corporation. Palisade’s strategy is to have the surviving company acquire, or merge with a company that will have a public market valuation in excess of the target’s actual cost. If successful, the surviving corporation’s stock will be more valuable then the Payment Right. It is not unrealistic to assume that a prudent acquisition will offer a 50 to 100 percent premium to the Payment Right (essentially book value). Additionally, if the deal is done within two years the resulting annual IRR could top 50 percent under a number of different scenarios.

THE FORMULAS:

Section 2.01 of the merger agreement sets forth how the value of the Payment Right is determined. These formulas were designed to account for two main variables: the amount of money that would be available through liquidation and the timing of when the proceeds are available. Based on events that have already transpired, I believe there will be in excess of $14 million of liquid distributable assets (as defined in the agreement) by March 31, 2003. If this is true, the first formula can be ignored. In the event that the realized liquid distributable assets are less than $18 million on June 30, 2005 then the second formula calculates the value of the Payment Right. My base-case, best-case and worst-case scenarios assume realized liquid distributable assets of $17 million ($0.80 per share), $18 million ($1.10 per share) and $16 million ($0.52 per share) respectively.

VARIABLES:

On June 30, 2002 shareholder’s equity was 17,857,000. There are some off balance sheet liabilities, most significant of which are a retirement agreement with its founder and former president, a potential lease liability (which also has the potential to be an asset if the premises remains subleased throughout the lease term), costs associated with winding down the business and two executive compensation agreements which entitle the executives to 20 percent of the excess distributable assets above $10,000,000. On the positive side, subsequent corporate transactions have been consummated at amounts either at or close to book value (as written down to approximate net realizable values) or well in excess of book value. Most significantly, the sale of the Heli-Coil and Dodge licensing rights for $4,000,000 and the Gough licensing property and accounts receivable for $450,000 had very little attributable basis. Accordingly, the September 30, 2002 shareholder’s equity should be in approximately $20,000,000 (my rough guess). Additionally, continuing operations and contingent proceeds from the sale of businesses should provide meaningful income though the wind down period.

Based on my review of the June 30, 2002 10-Q, subsequent press releases (8-K’s) and conversations with management, I believe my estimates presented here are conservative. I anticipate REFAC’s third quarter 10-Q and proxy statement will provide more clarity/transparency into the situation.

Additionally, the value of the Lottery Ticket depends on the decisions made by management at Palisade Capital. I consider the implied option value to be significant considering the downside protection of the Payment Right.

Catalyst

Approval of the proposed merger between REFAC and Palisade Concentrated Equity Partnership, L.P.